Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.

A few weeks ago, I noted that our recession warning composite was on the brink of a signal that has always and only occurred during or immediately prior to U.S. recessions, the last signal being the warning I reported in the November 12, 2007 weekly comment Expecting A Recession. While the set of criteria I noted then would still require a decline in the ISM Purchasing Managers Index to 54 or less to complete a recession warning, what prompts my immediate concern is that the growth rate of the ECRI Weekly Leading Index has now declined to -6.9%. The WLI growth rate has historically demonstrated a strong correlation with the ISM Purchasing Managers Index, with the correlation being highest at a lead time of 13 weeks.

Taking the growth rate of the WLI as a single indicator, the only instance when a level of -6.9% was not associated with an actual recession was a single observation in 1988. But as I've long noted, recession evidence is best taken as a syndrome of multiple conditions, including the behavior of the yield curve, credit spreads, stock prices, and employment growth. Given that the WLI growth rate leads the PMI by about 13 weeks, I substituted the WLI growth rate for the PMI criterion in condition 4 of our recession warning composite. As you can see, the results are nearly identical, and not surprisingly, are slightly more timely than using the PMI. The blue line indicates recession warning signals from the composite of indicators, while the red blocks indicate official U.S. recessions as identified by the National Bureau of Economic Research.

The blue spike at the right of the graph indicates that the U.S. economy is most probably either in, or immediately entering a second phase of contraction. Of course, the evidence could be incorrect in this instance, but the broader economic context provides no strong basis for ignoring the present warning in the hope of a contrary outcome. Indeed, if anything, credit conditions suggest that we should allow for outcomes that are more challenging than we have typically observed in the post-war period.

Unthinkability is Not Evidence

One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and deleveraging risks we currently observe are, from that context, wildly "out of sample." To form valid expectations of how the economic and financial situation is likely to resolve, it's necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don't seem to be contemplating.

In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and "average" behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.

One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and deleveraging risks we currently observe are, from that context, wildly "out of sample." To form valid expectations of how the economic and financial situation is likely to resolve, it's necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don't seem to be contemplating.

Well said. I hear that attitude all the time especially here at the Fool. What many "bulls" fail to realize is "bears" or what I like to call "skeptics" don't want to be "bearers or bad news" (sorry for the pun). But arguments that I hear from the bulls are along the lines of "it wont happen to us" "US is stronger than [insert struggling country here]" "US wont lose its reserve status because there are no replacements", so on and so forth. All I can say is never say never. A couple years ago people were saying that housing prices could never fall. We all know how that turned out....

>>Well said. I hear that attitude all the time especially here at the Fool. What many "bulls" fail to realize is "bears" or what I like to call "skeptics" don't want to be "bearers or bad news" (sorry for the pun).

Exactly!!! I am not "rooting" for the economy to crash! I don't want the SPX to lose >60% of its value in the next 3 years! My point in posting and being bearish is because I think it is likely. I am one poor blogger / investor / trader. I can't change the macro economic situation. But I have spent years trying to understand it. And it looks bad and is getting worse all the time.

I would much rather be bullish, and buy every dip because the ecnomic outlook will be getting better all the time. But that time was not March 2009, it sure as hell isn't now, and it won't be while the SPX is four digits. Once some of this crushing debt is cleared and the market reacts to it and digests it, then I will start thinking about a bottom, and not before. This is not what I am rooting for, this is just the reality of the situation.

>>But arguments that I hear from the bulls are along the lines of "it wont happen to us" "US is stronger than [insert struggling country here]" "US wont lose its reserve status because there are no replacements", so on and so forth. All I can say is never say never. A couple years ago people were saying that housing prices could never fall. We all know how that turned out

Moreover, from a valuation standpoint, a further market trough would not even be "out of sample" in post-war data. Based on our standard valuation methods, the S&P 500 Index would have to drop to about 500 to match historical post-war points of secular undervaluation, such as June 1950, September 1974, and July 1982. We do not have to contemplate outcomes such as April 1932 (when the S&P 500 dropped to just 2.8 times its pre-Depression earnings peak) to allow for the possibility of further market difficulty in the coming years. Even strictly post-war data is sufficient to establish that the lows we observed in March 2009 did not represent anything close to generational undervaluation. We face real, structural economic problems that will not go away easily, and it is important to avoid the delusion that the average valuations typical of the recent bubble period represent sustainable norms.

so very true. There is an element that has downright animosity for anyone who says anything negative whether it be here or elsewhere, and whether it has validity or not.

yeah I'm not sure why bulls have such such hatred for us so called "bears". I do't think I'm a "bear" or overly neagtive person but frankly I don't like what I'm seeing macro wise right now.

I think it's an almost American cultural thing. We love to believe in hope even when common sense clearly specifies otherwise.

When I've posted about scam stocks I get outright attacked often by the very people scammers are ripping off. I tried to help these people and they hated me for it. Well to be fair it's hard not ridicule some of the scams I see. :)

But it's always been that way. You should my emails from 2000 (and 1999 to be fair! now that was a rally that made NO sense what so ever.). I'm no genius but tech valuations were just insane back then.

people hated my guts! and then some of the very same ppeople thought I was nuts in 2003 for being bullish .

I'm not always right of course (e.g. could have done much better in 2009 than I did), but being opportunistic and being able to see the situation for what it is, is what any survivor on wall street does.

It's just America, we hate negativity I guess, whether it be at party, a city council meeting or in markets....

Pertaining to wishing for negative outcomes, or loss for my fellow Earthlings, that is not true. If one takes a step back and observes the entire system and it's actual function, it is obvious that for mainstreet to thrive, those holding the reigns must be taken down a notch. That requires paradigm shift, and it will be uncomfortable, and time consuming, but the many suffering for the good of the few must be reversed. I'm just talking about simple balance here, nothing mystical or esoteric, or negative. How much longer can the sheriff of Knotingham run the forest? (It will seem like eternity, and even the most pro-authoritarian will eventually sicken with the efforts to hold back nature, and desire change. That's when it will come around.)